Volatility is a two-sided coin when it comes to forex trading. On the one hand, volatility is how forex traders are able to turn a profit, especially when looking to make a quick buck off of short-term trades.
On the other hand, increased volatility means less certainty about the market’s movements. When you’re trying to make trades based on your best understanding of market trends, you don’t want to get caught by surprise by market volatility that moves prices in a direction you didn’t anticipate.
If you want to capitalize on volatility in the market, it’s helpful to lean on popular volatility indicators that can help you make sense of the chaos appearing on forex charts. Read on for a basic volatility calculation to use in your trading strategy, along with six indicators with a proven track record of helping traders determine volatility when assessing trade opportunities.
How to Calculate Volatility
While a number of online forex tools and calculators can determine volatility for any given currency pair, it’s helpful to understand how volatility is calculated to help you identify instances where it has developed—and to assess the strength of that volatility when deciding whether to open a new position.
One way of calculating volatility is to determine the standard deviation of the variance of a currency pair’s value over a fixed period of time. To make this calculation, you will need to add together the price change from each day and divide by the number of days to determine the average price.
Once you’ve calculated the average price, subtract it from the price change for each day. Some of these will have negative values since the price change on a given day will be below the average, so square all of these deviations to cancel out negatives and make sure you’re working with all positive numbers. Add these numbers together, then divide by the number of days to determine the variance. Calculate the square root of this variance to identify the standard deviation. Many traders will use this standard deviation to identify volatility. If the price change of a currency pair exceeds this standard deviation, it indicates volatility and may present a strong trading opportunity.
While standard deviation alone is not an ironclad marker of volatility, it can be used alongside the following technical indicators to affirm signs of volatility for a currency pair.
Bollinger Bands
Bollinger Bands are a measurement that goes two standard deviations (about 95%) above and below the 20-day moving average. When the distance between the bands widens, it illustrates increased market volatility for the currency in question. A smaller distance, by contrast, signals less volatility.
Traders can use Bollinger Bands not only by assessing overall volatility for a forex listing but also by using the candle’s proximity to one of the bands. When the candle touches or nears a Bollinger Band, it signals a strong possibility for retracement, and traders may be tempted to open a position in hopes of cashing in on that impending movement.
Advantage: Bollinger Bands can be adjusted to measure three standard deviations over a larger period of time.
Disadvantage: Like other technical indicators, Bollinger Bands rely on historical data that may be irrelevant if volatility is being impacted by current events.
Average True Range
The average true range (ATR) uses three simple calculations. To determine the ATR, subtract the current day’s low from the current day’s high. Then subtract the previous day’s close from the current day’s high. Finally, subtract the current day’s low from the previous day’s close to end up with three separate values.
The average true range for a currency pair is the highest of those three values. The larger that number is, the higher the expected volatility for that forex pairing.
Advantages: Beginners can quickly learn how to use ATR in their trading strategy, and this volatility measurement tool can also help you set stops and price targets based on the strength of that volatility.
Disadvantages: ATR is a simple calculation for traders to use, but it also has limitations. For example, the ATR doesn’t indicate the direction of movement for a possible price swing—it scores only the likelihood of that price swing happening.
The ATR is also a lagging indicator rather than a leading one, which means it’s not as quick to identify promising trade opportunities—a disadvantage if you’re hoping to quickly capitalize on market volatility.
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Keltner Channel
The Keltner Channel analyzes price movements relative to the lower and upper moving averages for a forex currency pair. This indicator is actually a combination of the ATR and the exponential moving average (EMA). Although the Keltner Channel may have a similar appearance to Bollinger Bands, the proper way to use this indicator to analyze volatility requires a different approach.
Whereas Bollinger Bands represent two standard deviations above the 20-day moving average, the Keltner Channel is much narrower: Its range is defined by drawing a band that is twice the size of the ATR on either side of the 20-day EMA.
Traders should watch for price movements that break above or below these Keltner Channel lines. This indicates a likelihood that prices will continue to trend in that direction, offering some quick profit taking on impending volatility.
Advantage: Even when price activity fails to reach the limits of the Keltner Channel, declining activity may reflect declining price volatility.
Disadvantage: The Keltner Channel is often slower to identify volatility than other indicators, particularly Bollinger Bands.
Parabolic Stop and Reverse
A parabolic stop and reverse (PSAR) is a pattern that creates a parabolic curve on the forex chart, with dots that appear above or below the price based on the trend movement of the price. Traders can use changes in the placement of the dots to identify opportunities for trades.
When the dots switch from above the price to below, for example, it means that trading activity is generating upward momentum, resulting in a buy opportunity. Conversely, when the dots move from below to above, it can indicate a shift that represents a sell opportunity. This indicator can help traders make sense of volatile conditions and find chart trends that offer potential profit.
Advantage: PSAR offers a simple visual interpretation that makes it easy to evaluate and track volatility.
Disadvantage: In cases where volatility and price momentum aren’t aligned, PSAR may change its indications too often to be of use for traders looking to use it to gauge volatility.
Momentum Indicator in MT4
For MetaTrader 4 users, the momentum indicator, also known as the rate-of-change indicator, is a volatility indicator that can be used to analyze the speed of a price movement. The momentum indicator easily illustrates the speed and strength of a price movement on a numerical spectrum. The more positive the number is, the stronger the currency pair’s upward trend—which would recommend a buy for traders. By contrast, a pair’s downward trend is stronger when the momentum indicator is negative.
Additionally, the movement of this indicator can also identify new trading opportunities. Moving from a negative value to a positive value is a strong buy signal and vice versa.
Advantage: The momentum indicator can be very helpful in pinpointing potential highs and lows for a volatile currency pair.
Disadvantage: This indicator can generate a lot of false signals, especially if price momentum isn’t moving in one strong direction.
Volatility Squeeze
The volatility squeeze is actually a combination of both Bollinger Bands and the Keltner Channel, identifying a possible breakout opportunity for a currency pair. The volatility squeeze occurs when Bollinger Bands move inside the Keltner Channel.
Typically, Bollinger Bands sit outside the Keltner Channel, but a period of consolidation can pull them in, creating a narrowing that may at first appear to indicate reducing volatility. The Keltner Channel, however, provides context that can help traders understand this narrowing as a possible leading indicator for a breakout in the near future.
Advantage: Volatility squeeze can be a great tool for confirming volatility and forecasting swift movements in price action.
Disadvantage: The Keltner Channel’s indications can sometimes lead traders down the wrong path if Bollinger Band indicators are pointing to a decline in volatility.
Volatility can be your best friend or your worst enemy in forex—it’s all about how you understand that volatility and how you attempt to capitalize on these market conditions while minimizing your risk. These volatility indicators will help you get a better read on an uncertain situation, which could lead to some timely trades that turn volatility into a winning proposition.
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